What are Liquidity Pools in Decentralized Finance (DeFi)?
- Liquidity Pools are used in the crypto space and are the backbone of major decentralized finance applications, as they depend on these pools to run correctly.
- Likewise, the Cross-Chain Bridge works with Liquidity Pools and smart contracts, allowing users to move assets between blockchains such as Ethereum or BNB Smart Chain (BSC).
- Liquidity Pools are funds put together by users of a platform and locked in a smart contract. Popular DeFi applications such as Uniswap, a major decentralized exchange, have billions of dollars in value locked in their pools. Each dApp (decentralized application) uses them in different ways to provide different services.
This article will explain the basic functionalities of Liquidity Pools and how the Cross-Chain Bridge implements them to connect Blockchains seamlessly.
How Liquidity Pools Work
- Smart Contracts are used to lock liquidity in the form of crypto assets for DeFi applications, such as Decentralized Exchanges (DEXs), to offer swaps between different cryptocurrencies.
- In contrast, centralized exchanges depend on order books and external market makers to provide liquidity to enable users to trade.
- In Decentralized Exchanges, a single Liquidity Pool uses two assets, creating a new market for the trading pair. For the buyer to buy, there only needs to be sufficient liquidity in the pool of both assets of the trading pair.
- Each swap modifies the price of the assets based on a pricing algorithm known as Automated Market Maker (AMM), which also manages the liquidity of the pool according to the trading activity.
- The liquidity of these pools needs to come from somewhere. Liquidity providers typically deposit an equal ratio of tokens (50/50) and are incentivized based on the amount of liquidity they supply to the Liquidity Pool. When there is a swap, the transaction fee is distributed proportionally among all liquidity providers. (Learn more about the risk of Impermanent Loss).
- Liquidity providers receive LP tokens according to the number of tokens they supply to the pool. Earned fee tokens are distributed proportionally to each user’s share of the pool; this is known as Liquidity Mining.
The above is one of many examples of Liquidity Pools in DeFi. Over time, we have seen different implementations of these and how they have evolved to provide additional services, as in the case of the Cross-Chain Bridge.
How the Cross-Chain Bridge uses Liquidity Pools?
- In contrast to the liquidity pools in Decentralized Exchanges, the Cross-Chain Bridge uses single-asset liquidity pools, which implies that liquidity providers are never exposed to the risk of Impermanent Loss.
- To incentivize liquidity providers, they can deposit their LP tokens in the Liquidity Mining Pools or the available BRIDGE Farms.
- When there is enough liquidity in the pools of the connected networks such as Ethereum and Binance Smart Chain (BSC), users can bridge their tokens between them.
- When moving tokens, for example, USDT, from Ethereum to Binance Smart Chain (BSC), the user deposits the tokens in the Cross-Chain Bridge. The multi-sig oracle validates that there has been a transaction and releases the tokens in the target network using tokens from the USDT liquidity pool on BSC. If there is not enough liquidity in the destination network, the transfer does not work.
- Projects and users can provide liquidity in the pools on different Blockchains to be permissionlessly listed on the Cross-Chain Bridge, the same way as on a DEX.
Check our Gitbook to learn more.
Liquidity Pools are simple in definition, but their implementation is diverse, and thanks to this technology, we have experienced the rise of DeFi.